Despite the turbulence in the U.S. economy fueled by inflation, international tensions and rising mortgage rates, the private-label securities (PLS) market recorded a strong first quarter, at nearly $43 billion in issuance, and is projected to finish 2022 with record volume.
That $43 billion mark represents the second-highest issuance total since the global financial crisis (GFC) some 15 years ago and also was nearly two-and-a-half times above issuance volume for the first quarter of 2021, according to a recent market assessment by Kroll Bond Rating Agency (KBRA).
The report focuses on so-called RMBS 2.0 deals, defined as all post-GFC residential mortgage-backed securities issuance in the prime, nonprime (including non-QM) and credit-risk transfer (CRT) spaces — the latter typically issued by the government-sponsored enterprises.
“In our view, this [performance] is due to the inherent diversification of RMBS 2.0 deals among subsectors differently sensitive to interest rates, a large variety of issuer types, and a quickly appreciating home-price environment,” the KBRA report states.
Those dynamics lead KBRA to project record nonagency (private label) residential mortgage-backed security (MBS) issuance for the year, though at a declining rate in the coming quarters.
“We continue to expect 2022 will close as a record post-GFC issuance year with almost $131 billon in aggregate [RMBS 2.0] issuance,” KBRA reports. “… KBRA expects Q2 2022 to close at approximately $38 billion, and Q3 to decrease further to $29 billion across the prime, non-prime, and credit-risk transfer segments because of rising interest rates and an unfavorable spread environment for issuers.
“… To date,” the KBRA report continues, “issuance spreads [have] widened rapidly for all sectors as supply and demand volatility hit nearly all-time highs.”
The spread is a measure of relative yield value between two types of debt instruments, such as a benchmark U.S. Treasury bond and a mortgage-backed security. As spreads widen in an unfavorable way for issuers, MBS prices tend to decline. Bond prices, however, move in the opposite direction of yield — with a higher yield (the ratio of a bond’s coupon to its price) deemed compensation to an investor for the added risk in a volatile market.
Among the factors industry experts contend are contributing to the volatility in the MBS market, and consequent deal-execution challenges, are fast-rising interest rates in combination with the Federal Reserve’s tapering of its MBS holdings.
“So the Fed is clearly on a rate-hiking cycle,” said Seth Carpenter, chief global economist at Morgan Stanley, in a presentation at the recent Mortgage Bankers Association’s (MBA’s) Secondary and Capital Markets Conference & Expo in New York City.
“They raised rates 25 basis points in March,” Carpenter continued. “They raised rates 50 basis points in the May meeting. And [Fed] Chair [Jerome] Powell was clear that the next couple of meetings looked like 50 basis points [hikes], so call it the June meeting and the July meeting.”
Carpenter said Morgan Stanley expects rate bumps after July are likely to return to the 25 basis points level until “we get to a peak of about 3.25% [for the Federal Funds rate] early next year.”
For now, the Fed is not purchasing new MBS to hold in portfolio, and it also is allowing a portion of its existing portfolio to run off its books as those securities mature. But what happens if the Fed’s run-off strategy isn’t sufficient to meet its MBS divestment goals?
“They’re going to let their mortgage-backed security portfolio prepay without being reinvested, and there will be a cap of $35 billion [a month] starting at half that for the next three months,” Carpenter explained. “Our forecasts from my colleagues at Morgan Stanley suggest that given what the Fed has in their portfolio, [MBS] prepayments [run-off] are unlikely to get up to $35 billion a month.
“Will they end up then selling mortgage-backed securities on an outright basis to get up to that $35 billion level? I think the answer has to be the following: We’re not sure.”
The Fed’s continuing effort to wind down its $2.7 trillion MBS portfolio is expected to fuel widening spreads in the MBS market because it creates more supply to be absorbed, Bloomberg intelligence analyst Erica Adelberg explained in a recent Bloomberg report. That, in turn, puts downward pressure on pricing,
Regardless of how the Fed proceeds in shrinking its MBS portfolio, however, Mike Fratantoni, chief economist for the MBA — who also spoke at the recent MBA conference — expressed confidence that the MBS market will weather the storm. He described it as the “second most liquid market in the world.”
“There are buyers domestically and abroad for mortgage-backed securities,” he added.
The issue ahead that Fratantoni zeroed in on is investors’ reactions to perceived market volatility, sparked by uncertainty. “Even if it’s not going to result in a [Fed] sale [of its MBS holdings] … every sort of rumination about that has the potential to lead people to change their position,” he said.
Sonny Weng, vice president and senior credit officer at ratings firm Moody’s Investors Service, explained in a recent interview focused on the PLS market that because of inflation and the volatile rate environment, coupled with an abundance of MBS supply — due, in part, to the Fed’s monetary policies — investors are demanding a higher MBS coupon, or the rate of interest paid annually on a note at par value.
The gap between rates on mortgages currently, compared with the much lower rates in 2021, also is creating another layer of deal-execution challenges. A recent market report by digital mortgage exchange and loan aggregator MAXEX reflects that reality.
“…Private-label securitization (PLS) spreads continued to move wider throughout April as issuers digested lower-rate mortgages [3% or lower] that remain in inventory as current market rates rise rapidly,” MAXEX states in its May market report.
Weng added: “And obviously, when your mortgage pool has a lower [interest] rate, and you also have to cover certain fees, a higher coupon translates into a higher funding cost for the issuers.”
There is a light at the end of that pipeline, however, according to MAXEX. “We expect this trend to continue in the short term until issuers’ pipelines stabilize and, over the coming months, note rates closer to 5% migrate to PLS [private label securities],” the company’s report states.
KBRA also indicates that impacts from the pandemic and the war in Ukraine “are important factors in our issuance projections for 2022, and these factors may also influence 2023.”
“Mortgage rates are generally expected to increase further as the Fed attempts to cool down rampant inflation and the housing market, impacting issuance as well,” KBRA’s market-forecast report states. “…We expect the prime sector to decline in 2022, mainly due to sharp interest rate increases that have decreased overall mortgage production….
“Similar themes could continue through 2023, causing prime issuance to be negatively impacted further. The non-prime sector’s expected issuance is projected to increase moderately in 2023 as spreads normalize after rising precipitously in Q2 2022.”
Another bright spot going forward this year for the PLS market, according to KBRA and MAXEX, is the potential for solid non-agency PLS issuance backed by investment properties and other more “esoteric” offerings.
“… We are still seeing an increase in the number of second homes and investor property loans being traded through the exchange to avoid the LLPA [loan-level price-adjustment] increase instituted by the FHFA [Federal Housing Finance Agency] for second-home and high-balance loans delivered to the agencies after April 1,” the MAXEX May market report states.
KBRA reported that MBS issuance backed by mortgages on nonowner-occupied properties (NOO), such as investment properties and second homes, “was strong in Q1 2022, with over 10x year-over-year growth.”
“We continue to expect further issuance in this segment…,” the KBRA forecast report states. “This expectation is partly due to existing NOO securitization pipelines built through the end of 2021 and early 2022.
“… In addition to traditional RMBS 2.0 issuance, reverse mortgage, mortgage servicing rights-backed issuance, home equity line of credit-backed deals, PLS CRT, Ginnie Mae early-buyout (EBO), and other esoteric RMBS transactions are also poised to increase in the remainder of 2022 and 2023 as interest rates rise further.”